Tuesday, September 16, 2014

Why hedging in Forex is important | a practical example

The Financial regulatory authorities
in the USA have, for some time now, outlawed what is known as “hedging” in
retail Foreign Exchange trading. This involved the taking of an identical size
position to an established trade, but in the opposite direction. At first sight
it can seem like a somewhat futile exercise as the positions cancel each other
out while at the same time attracting the usual transaction costs in terms of
spread, commissions and swaps (a swap is the cost of rolling over a position
that one wishes to maintain overnight). For completeness is must be stated that
while they sound onerous, for serious traders these costs are reasonable.

The reasons for disallowing retail
Forex hedging in the USA seem to have to do with the fear that unscrupulous
brokers will take advantage of less sophisticated traders in relation to the
costs mentioned, and that hedging can, in certain circumstances, reach complex
proportions. Apart from the fact that it is the job of the authorities to weed
out dodgy traders without imposing restrictions on their clients, the ban
smacks of “Big Brother” patronising behaviour.

Here at OmiCronFX we have a good use
for hedging (our broker is not in the USA), and it has served us well. To see
why, it is first of all necessary to explain why it might be necessary to
maintain a position in the face of short-term risk to its profitability. Nobody
has done this better than Edwin Lefèvre, in his book “Reminiscences of a Stock
Operator”, published in 1923. He relates the story of old Mr.
Partridge, otherwise known as “Turkey”, who refuses to sell his holding in a
certain stock when advised to do so by the man who gave him the tip for it in
the first place. The story makes a play on the word “position”, and the
following is an extract:

"I
beg your pardon, Mr. Harwood; I didn't say I'd lose my job," cut in old
Turkey. "I said I'd lose my position. And when you are as old as I am and
you've been through as many booms and panics as I have, you'll know that to
lose your position is something nobody can afford; not even John D.
Rockefeller. I hope the stock reacts and that you will be able to repurchase
your line at a substantial concession, sir. But I myself can only trade in accordance
with the experience of many years. I paid a high price for it and I don't feel
like throwing away a second tuition fee. But I am as much obliged to you as if
I had the money in the bank. It's a bull market, you know." And he
strutted away, leaving Elmer dazed.

What old Mr. Partridge said did not mean much
to me until I began to think about my own numerous failures to make as much
money as I ought to when I was so right on the general market.

The
more I studied the more I realized how wise that old chap was. He had evidently
suffered from the same defect in his young days and knew his own human
weaknesses. He would not lay himself open to a temptation that experience had
taught him was hard to resist and had always proved expensive to him, as it was
to me. I think it was a long step
forward in my trading education when I realized at last that when old Mr.
Partridge kept on telling the other customers, "Well, you know this is a
bull market!" he really meant to tell them that the big money was not in
the individual fluctuations but in the main movements that is, not in reading
the tape but in sizing up the entire market and its trend”.

A practical example

During the weekend of 5th September
last there was a gap down in the GBPUSD pair, after the publication on the
Sunday of a poll that suggested that there was a real possibility that Scotland
would vote to be independent in their forthcoming referendum (see chart at top).

The following week we wanted to hold
on to a long position in this pair, for exactly the reasons outlined in the
extract from Lefèvre ‘s book above. However, a similar gap down could be
disastrous for profitability because, as the markets are closed over the weekend,
our Stop Loss order would be ignored. The solution: put on a hedge of the same
size position in the opposite direction. Then, in the event of a gap down, the
hedge will capture as profit any amount that was lost from the original
position as a result of the gap. The hedge can be removed as and when
appropriate.

All associated costs are well within
the bounds of what would be regarded as a very affordable insurance policy on
the risk involved.